Three Bullets for Draghi as ECB Set to Downgrade Growth

Another crucial meeting for the European Central Bank (ECB) is due Thursday with analysts across Europe looking ahead to three different policy changes that ECB President Mario Draghi could announce, which have the potential to shake up the euro and the banking sector, while also downgrading growth for the euro zone at the same time.

The ECB cut its benchmark refinancing rate by 25 basis points last month to a record low 0.5 percent, its first cut in 10 months. Morgan Stanley expects another 25 basis point cut on Thursday, but most other analysts expect that a pickup in consumer sentiment, manufacturing and inflation in the last month will be enough for the central bank to hold off from cutting rates.

Instead it's the potential for a cut in the banking deposit rate that is causing more of a stir. The euro fell sharply against the dollar at last month's meeting after Draghi said the bank is technically ready for negative deposit rates - effectively charging banks to hold money overnight at the ECB.

"The debate on the pros and cons of a deposit rate cut on the ECB Council is likely to be finely balanced," Morgan Stanley said in a research note on Friday.

"Using zero or even negative interest rates allows the ECB to leverage current policy rates through forward guidance, to avoid a deeper rift in the Governing Council on the QE (quantitative easing) question, and to map out a credible exit from its uber-expansionary policy stance."

Morgan Stanley predicted that political considerations and practical constraints might prevent a swift implementation of a negative deposit rate and said a cut was more likely in the second half of the year. Regardless, the euro is likely to be volatile if Draghi says anything on the issue in the press conference following the decision.

"Past experiences from other countries shows that negative deposit rates were mainly used to weaken the exchange rate but not to revive lending. The danger is that banks actually increase lending rates to offset the margin costs from negative deposit rates. Even if technically possible, we argue that negative deposit rates currently still resemble too much of a gamble for the ECB to dare to implement them," Carsten Brzeski, senior economist at ING said in a research note on Monday.

A third tool that the ECB could bring to the table could be a lending scheme for small and medium sized businesses, analysts said. In the absence of any formal U.S. style quantitative easing (QE) injection - which Draghi has previously opted against, citing the differences in capital markets in Europe - a scheme similar to the U.K.'s Funding for Lending could be implemented.

"Draghi is likely to provide a progress report on plans to ease SME financing conditions," RBC Capital Markets said in a research note, but added that it expected no formal announcement that an agreement is yet in place.

"At the press conference, the focus will also be on further steps to kick-start a SME-backed [asset backed securities] market and ways to do so. Here, we believe progress could be slow and may disappoint markets," Credit Suisse said.

One definite announcement expected on Thursday is the staff predictions for growth. In March the ECB estimated gross domestic product (GDP) of -0.5 percent for 2013 on average and around 1 percent for 2014. Economists at RBC, Daiwa Capital, Morgan Stanley and Credit Suisse believe a slight downward revision is due, while inflation projections could also fall due to lower oil prices and abandoned hikes in value added taxes (VAT).

"The absolute level of confidence indicators is still depressed, unemployment remains at record highs and monetary data also does not (yet) point to a quick rebound of economic activity. The ECB staff projections, which will also be presented on Thursday, should confirm this picture," Brzeski said.